Vintage Wine Turns Sour for Financiers

When the folks at a private equity firm gather at the holiday party refreshment
table to talk about "vintage," they aren't commenting on the Château
Pétrus.

The world of private equity financing doesn't have high visibility, but it
is big business behind the scenes. Unlike venture capital outfits - which provide
startup money to very early-stage companies - those who play this game grab
existing private companies, often through leveraged buyouts (LBOs). Each year's
investments are referred to as vintages, with some being more highly drinkable
than others.

Now, some of the recent vintages look like they'll turn out to be little more
than vinegar.

Private equity investing has never been for the faint of heart. But investors
continue to engage in it, because the payoff can be substantial. And for the
first few years of the new millennium, it was a go-go place to be. With so
much easy money sloshing around, the number of PE deals exploded, totaling
over half a trillion dollars at the manic peak in '07.

Then came the crash:

It's important to remember that credit was not a single bubble. It was a bubble
machine. It created the housing bubble, which fueled the personal debt bubble
(which in turn popped the housing bubble, but that's another story). The mortgage
market gave birth to a whole new range of derivatives, things like collateralized
debt obligations (CDOs), mortgage-backed securities (MBSs), and the rest of
the acronyms we've all become familiar with, even if we don't quite understand
what they do. (Don't be embarrassed, neither did the financial geniuses who
swapped them like baseball cards.)

Frantic trading in these newly printed scraps of paper created its own bubble,
manufacturing an incredible amount of seeming liquidity in a very compressed
time frame. We know the ultimate consequences to the balance sheets of our
banks, and our government, by now. But there was more to it than that. The
capital these transactions threw off had to go somewhere, and suddenly well-capitalized
investors were pouring their phantom profits into something perceived as more
solid: private equity firms. Presto, yet another bubble.

In a mania, all investments are at the mercy of the greater fool. As in: if
you can't find one, you're it. Doesn't matter if we're talking housing, stocks,
commodities, or whole companies. The last man standing is left staring into
an abyss in which there are no buyers.

With PE deals, investors don't acquire companies because they want to own
them. They buy in because they expect to sell to a higher bidder. Here are
their three exit strategies:

wait until the company goes IPO and clean up when you sell your stock into
the liquid public markets;

arrange for a takeover by a corporate entity; or,

pawn it off on another PE firm in a secondary transaction.

And this is what's happened in those areas over the past eight years:

Compare the two graphs, and it's immediately apparent that PE firms are sitting
on a lot of properties that'll be difficult to move. They invested an unprecedented
amount right at the same time as the bottom was falling out of an overheated
exit market, returning back to normal levels of deal flow in just two short
years.

Furthermore, while it looks like IPOs in general recovered a bit in 2009,
they still totaled just 25 from the ranks of PE-backed companies. And even
that number may be misleading. According to PitchBook, a respected industry
analyst, "a number of these IPOs did not represent full exits but were used
as a means of raising capital to pay down debt and provide investors with partial
returns."

It Only Gets Worse

At the same time, much of the huge money stack they piled up through '07 is
still there. It doesn't move because, in the current environment, there's no
point in adding more companies when they can't profitably dispose of the pile
they already have. And that's led to a boatload of uninvested capital - a massive
cash overhang estimated at some $400 billion:

Excess Funding + a Bloated Portfolio = ??

Well, that is the question. First of all, you can save the pity you might
slop onto these firms. They are, after all, making some kind of return on the
money they hold. Beyond that, though, we're looking at the potential for some
pretty vinegary vintages.

Generally, the wait time for a vintage to mature - i.e., for the investment
to show a profit - is about five years. So the more than $1 trillion thrown
into PE firms between 2005 and 2007 will be expected to yield fine wines from
now through 2012.

Whether, instead, we'll hear only whines, no one can say for sure. But for
comparison purposes, we can look at PE's sister market, venture capital. In
a recent analysis of VCs, investment advisor Cambridge Associates reported
that returns were off steeply from their heyday in the early '00s, falling
from 36% to 14% just following a similar flood of increased inflows during
the early part of last decade. A similar decline in returns from private equity
investments - with lower risk and lower expectations than VCs - could take
them down into the single digits, if not close to or below zero. You might
as well be in T-Notes.

The takeaway is this: Private equity fuels the IPO market, as well as the
growth pipeline for big companies that can't grow only organically. But PE
firms are sitting on the equivalent of a bunch of drunken Vegas marriages,
having pledged "till death do us part" at the top of the frothy debt market.
All those unwanted spouses in the portfolio mean lower gains.

Add in the excess capital, much of which may end up being recalled by investors
tired of waiting for it to be invested, and the big firms - which grew cocky
playing with billions in this once-lucrative market - are likely in for some
lean years.

What does all this mean to you as an investor?

Well, you need to be wary of IPOs; many of the dogs will be trotted out, with
tails wagging and mouths closed to hide the rotting teeth. Also on the way
are diminished returns for the banks and insurance companies that back the
PE guys. And if equity prices remain at recent highs, there will probably be
a shakeout in the industry, as increasing numbers of companies look to global
public markets to raise money, instead of turning to private equity. A trend
that's already apparent with the incredible number of secondary offerings over
the past few months (in just two days this past September, nine were filed
or priced on U.S. markets), and the thawing global IPO market.

But remember that every crisis holds danger as well as opportunity. That's
the specialty of the editors of The Casey Report: to analyze emerging
mega-trends and find the best opportunities to profit from them. And if you
go along for the ride, you will be able to do the same. To learn more about
how to make money in a roller-coaster economy, click
here.

Alex Daley is the senior editor of Casey's Extraordinary Technology.
In his varied career, he's worked as a senior research executive, a software
developer, project manager, senior IT executive, and technology marketer.

He's a technologist who has collaborated on the development of cutting-edge
technologies, including: remote lie detectors that work invisibly across a
room, autonomous/robotic vehicles that can drive themselves unaided across
hundreds of miles of rugged desert terrain, computer vision systems that enable
computers to understand the depth in 2D photographs, lightweight composite
ceramics that can withstand artillery fire better than metal, maps of the human
genome, automated analysis of video for non-verbal communication cues, and
face detection and recognition for spotting people in photos and surveillance
videos.

But Alex's technological experience is only half the story. He's an industry
insider of the highest order, having been involved in numerous startups as
an advisor to venture capital companies. He's a trusted advisor to the CEOs
and strategic planners of some of the world's largest tech companies. And he's
a successful angel investor in his own right, with a long history of spectacular
investment successes.

Information contained herein is obtained from sources believed to be reliable,
but its accuracy cannot be guaranteed. The information contained herein is
not intended to constitute individual investment advice and is not designed
to meet your personal financial situation. The opinions expressed herein are
those of the publisher and are subject to change without notice. The information
herein may become outdated and there is no obligation to update any such information.
Doug Casey, entities in which he has an interest, employees, officers, family,
and associates may from time to time have positions in the securities or commodities
covered in these publications. Corporate policies are in effect that attempt
to avoid potential conflicts of interest, and resolve conflicts of interest
that do arise in a timely fashion. No portion of this web site may be extracted
or reproduced without permission of the publisher.

Doug Hornig joined the Casey team as a freelance writer on the former publication
What We Now Know, a perfect fit for someone with his wide-ranging interests. He
wrote nearly 125 articles for WWNK between early 2004 and late 2007. In October
of 2005, he assumed editorship of the Daily Resource column, to which was added
Casey's Daily Resource Plus in 2007. A steady contributor to Casey's Gold & Resource
Report, he also writes the occasional article for International Speculator
and other Casey publications.

A former Edgar Award nominee, finalist for the Virginia Prize in both fiction
and poetry, and a past winner of the Virginia Governor's Screenwriting competition,
Doug lives on 30 mountainous acres in a county that just got its first stop
light. He is an admitted political junkie, but hates all political parties.
Doug has authored ten books and has written articles for Business Week and
other renowned publications.

Information contained herein is obtained from sources believed to be reliable,
but its accuracy cannot be guaranteed. The information contained herein is
not intended to constitute individual investment advice and is not designed
to meet your personal financial situation. The opinions expressed herein are
those of the publisher and are subject to change without notice. The information
herein may become outdated and there is no obligation to update any such information.
Doug Casey, entities in which he has an interest, employees, officers, family,
and associates may from time to time have positions in the securities or commodities
covered in these publications. Corporate policies are in effect that attempt
to avoid potential conflicts of interest, and resolve conflicts of interest
that do arise in a timely fashion. No portion of this web site may be extracted
or reproduced without permission of the publisher.